Are financial stocks about to reward patient turnaround investors?

Ten years ago, the economic crisis was gathering pace and shares in the financial sector were in freefall. Since then, the fortunes of individual UK banks have been very mixed. These once-popular shares became pariahs that had no choice but to restructure and recapitalise. Plus they had to deal with various scandals and the challenge of low interest rates - and they still do.

So it’s no surprise that financial stocks - especially banks - have been marked down by the market over the past decade. Until now, only hardened value investors have shown much interest, but that has started to change. A trend we’re seeing right now in a number of shares across the financial sector is that they fit the investment profile of Turnarounds. It suggests that after a long period in the wilderness, some of these beaten up stocks are picking up momentum.

Banking on a recovery

One of the lessons of the credit crisis was just how difficult it is to understand banks and the assets they’re exposed to. Take Royal Bank of Scotland, which was a poster child for the crisis. Back in February 2007 it reported a record operating profit of £10.3bn and surprised the City with a 10% dividend hike. Even the write-downs RBS was making against bad debts in the US mortgage market didn’t seem like a major problem. Yet eight months later the bank essentially failed and was forced to take a government bail-out.

But RBS wasn’t the only bank with problems - the stories across the sector are well known, and some still rumble on. For instance, Barclays managed to recapitalise itself with the help of sovereign funds in Qatar. But the details of those deals have come back to haunt it, and its former executives are now facing fraud conspiracy charges!

But while the credit crisis caused problems for many banks, one of the biggest pressures for the sector since has been low interest rates. A longer-for-lower policy by the Bank of England to stimulate consumer spending has been tough on banks’ net interest margins. While rates have started to rise in the States, the UK is yet to follow suit.

But not all investors have been put off by these problems. Last September, Nick Kirrage who runs Schroders’ deep value-focused recovery fund,…

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That said, if you think there is a reasonable probability of a recession in the next 2-3 years - then in my experience it's a pretty difficult phone call for a broker to make to a fund manager
"We might go into a recession in the medium term, but that's already priced into the BARC, LLOY and RBS share prices."

Alternatively, you could just by BGEO (LON:BGEO) which has a stock rank of 87, and seems to do better on the "value" indicators than many of the UK banks (DYOR, I'm talking my own book.)

The link between margin and nominal rates could also break down (it's somewhat bizarre it hasn't already) so you could have a scenario of improved profitability despite low rates. Also reserving practices are probably over-stringent these days, so in good times you have operational leverage as fewer loans default than planned and a slice of profit is booked at maturity instead of forward as in the old days.

PS: Possible typo: "uncorrelated" is explained using the definition of "negative correlation".

I can understand this viewpoint, but here's the thing. There's no obligation to invest in the likes of Barclays (LON:BARC), Royal Bank of Scotland (LON:RBS) or Lloyds Banking (LON:LLOY) - or even Bank of America, Wells Fargo, ANZ, Westpac or any other very large bank. But that doesn't mean you have to rule out investments in the banking industry.

If you look in the U.S. market, there are a large number of sizeable, successful, conservatively funded and well managed regional banks that sailed through the financial crisis unharmed and have strong long term records - returning 11, 12, 13% per annum over long periods. Stocks like Cullen/Frost, Bank of Hawaii, Commerce Bancshares, and BOK Financial. Or in Sweden, Svenska Handelsbanken.

It is a mistake - understandable, but a mistake - to write off all banks en masse, in my view.

Having worked in the wholesale banking industry for over 20 years (and more by luck than judgement getting out in 2007/08), I think it is an error to think of banks as being in some way homogenous entities. In the same way as the Industrial classification covers a wide spectrum of different businesses, there are many different products and business lines and banks to varying degrees try to combine some or all of these under their own platforms. Some try to be all things to all people with a "Bank Assurance" model (Citi, JPM, Deutsche) whereas others specialise in particular product lines (e.g Goldmans, CSFB in investment banking), geographies (Stan Chart in the Far East) or sectors (Rabo in agri banking). Fashions and business models change over time but generally most banks tend to revert to their historic type (usually with their tails between their legs after they've bet the house on a new business line and failed) and the winners tend to be those that stick to their knitting and don't go on a frolick trying to catch the next big wave (usually when the first movers have taken the low hanging fruit and left all of the risk behind for the greater fools to get stuffed with).

In my view, much of the 2007/08 crisis was exacerbated by banks playing "me too" games throughout the noughties trying to expand into business lines they either didn't understand (e.g. US sub prime lending) or didn't have the risk management or culture to do properly (or in the case of Lloyds were dragged into via a shotgun wedding with a fundamentally broken HBOS by political necessity and a rose tinted view of the potential opportunity without doing any due diligence).

A couple of observations from my own experience. Critically, don't underestimate the value of, but general lack of, quality senior management in most banks due to poor succession management and the perverse view that being successful in a single business line (e.g trading junk bonds) necessarily gives an individual the strategic insight to run a complex business that is more than just a few numbers on a trading screen (or in the case of HBOS a few tins of baked beans on a supermarket shelf). If you can identify competent, decent, focused, disciplined and consistent management in a bank go for it.

Secondly, as an investor, I adhere to the adage, "boring is good". Go for banks with a clear, simple business model where ideally they have a good pedigree and consistent earnings flow through all parts of the business cycle (not just the "fat" years) and avoid those that keep chopping and changing strategy every few years on the whim of a charismatic CEO (or worse still the dreaded management consultants). In particular, many European banks are drawn like moths to a flame by the US capital markets and invest huge sums of money buying or building businesses to compete with the US behemoths on their home turf. It's sexy, it's high profile and they all think they can be the next Gordon Gekko but fail to realise it's a casino and the "House" is run for and on behalf of the domestic US banks through a combination of politics, legislation and more recently the judicial process (just take a look at how the sub prime sanctions have been/are being allocated). Home team rules apply and the Europeans are playing away. Plenty of Europe's finest have been broken on the rocks trying to play on the other side of the pond in a game that is fundamentally rigged.

I agree there are good banks out there and some make/will make decent long term investments. Absent the HBOS brain f**t, Lloyds should probably be one of them. After all, how hard can it be taking deposits paying 0.25% and lending money prudently with decent security at 10% but it's amazing just how many banks manage to mess it up trying to become something that they aren't!

When this article came out I did a spread sheet, which I shall explain later, and had a hard time analysing Banco Santander BNC. It is also a Turnaround but for some reason does not appear in Banking Services or Financials at all. It is not because it is a foreign bank, BGEO is there or because it is interlisted on other exchanges, HSBA is there.

In the end I had to import it (BNC) into a Portfolio to be able to analyse the Momentum components which was the object of the spread sheet.

The aim was to separate Price Momentum from Earnings Momentum. The result was interesting but inconclusive to anyone who follows the sector.

STAN and HSBA both surprised downwards at their last earnings announcement and they plus RBS have had positive EPS FY1 revisions.

If someone can tell me how to post an Excel spread sheet without the columns running into eachother then I shall share it.

Thank-you for taking the time to give instructions.
I have followed all the steps but in Notepad get lines of code.
Various other attempts to register a text or picture have not worked either. It would be a useful skill to master but other priorities prevent me going further now.

A comparaison of the charts and earnings surprises shows that geo-political events have FAR more impact on the share price than results.
Thus HSBA and STAN were very low in Jan and Feb 2016 when the world was coming to an end but were not affected by Brexit. LLOY and BARC, as UK exposed plunged. BNC suffered at both times.

If you're still trying to insert graphs, pictures etc., into a Stocko thread and are working on a Windows based PC you could try using the "Snip" application. See note #4 in the attached thread for a fuller explanation. Very flexible and can be used to incorporate anything (spreadsheet, photo, chart, text etc.) that you can see on your PC screen.